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The Law of Equity Compensation Is Not Great

I got into a friendly Twitter banter last night with a friend.

I was pushing my argument that we should repeal the taxes on transfers of stock to workers.

My friend Nick Ambrose (@nick_a_ambrose) was arguing that existing equity incentives were fine, especially incentive stock options. At least, I think this is what he was saying. Here is the start of our conversation:

Nick and I went back and forth a little more. I was pointing out that options are what companies do because they can’t do stock awards, because of the tax problems. He was arguing options or other currently available mechanisms are fine, or work just fine.

I pointed out that I think Fred Wilson agrees with me. Here is what Fred said:

I do not believe there is an optimal way to issue employee equity at this time. Each of the three choices; options, restricted stock, and RSUs, has benefits and detriments. I believe that options are the best understood, most tested, and most benign of the choices and thus are the most popular in our portfolio and in startupland right now.

Nick still didn’t agree with my idea, I don’t think. I finally told Nick I just disagreed with him, and smiled at him through Twitter.

I don’t think options are as good as stock awards. Here are my reasons:

Options have to be exercised; if not, they terminate.

I have seen companies with large groups of option holders see the option holders get quite anxious when the option termination dates start rolling in. The workers basically want the management of the company to create a liquidity event–go public or sell the company–so the workers can get liquidity for their options before they expire. I don’t believe this would happen in the same way if the workers held stock. Stock doesn’t have an expiration date.

Frequently workers quit when they are vested but before a company liquidity event. In these situations, workers frequently can’t exercise their options in full because the tax consequences are too severe. These workers miss out on some potential big gains. This is really unfortunate for the worker.

ISOs don’t solve these problems. Even though there is no ordinary income tax on an ISO exercise, there is an AMT adjustment. Sometimes the AMT adjustment results in the worker paying a lot of tax. More tax than the worker can afford to pay.

We need to fix worker equity compensation tax laws. We need to make the law better. The way the law works currently is not good enough.

The fundamental problem I would like to see addressed is this:

If a company wants to issue stock to a worker, the worker has to pay tax as if she received cash. This despite the fact that the stock is illiquid and can’t be sold. This causes company to issue stock options rather than issue stock to workers. But options are not as good as stock awards. The reason? Options expire. And once they are in the money exercising them triggers taxes that workers frequently can’t pay. This frequently robs workers of much of the value of the equity incentive. A sad result for workers.

My solution:

Let’s repeal the tax on transfers of stock to workers. This would directly address the problem described above. It could also help ameliorate wealth concentration by helping to spread the wealth around. This could ultimately help create more angel investors. These are all good things.

The fundamental question is: Do we try to make the law better, or do we leave it the way it is?

Stock Awards & Stock Bonuses

I am frequently asked how stock awards are taxed in the context of a private company issuing stock to employees or contractors as a work incentive.

The Taxation of Stock Awards and Stock Bonuses

Here is a short summary:

1) If the stock award is an award of fully vested shares, then the recipient of the award is taxed when he or she receives the shares, based on the value of the shares at that time.

2) If the shares are not vested, the recipient of the award is either:

–taxed on the receipt of the shares based on the value of the shares at the time of receipt, ifthe recipient makes an 83(b) election; or

–the recipient is taxed when the shares vest, based on the value of the shares when they vest. The trouble with not making the 83(b) election and waiting to be taxed is that when the shares vest they may be worth a lot more than when they were awarded. This can result in the recipient owing more in tax than the recipient can pay.

The one downside to restricted stock is you have to pay income taxes on the stock grant. The stock grant will be valued at fair market value (which is likely to be the 409a valuation we discussed last week) and you will be taxed on it. Most commonly you will be taxed upon vesting at the fair market value of the stock at that time. You can make an 83b election which will accelerate the tax to the time of grant and thus lock in a possibly lower valuation and lower taxes.

…

This taxation issue is the reason most companies issue options instead of restricted stock. It is not attractive to most employees to get a big tax bill along with some illiquid stock they cannot sell. The two times restricted stock make sense are at formation (or shortly thereafter) when the value of the granted stock is nominal and when the recipient has sufficient means to pay the taxes and is willing to accept the tradeoff of paying taxes right up front in return for capital gains treatment upon sale.

Employee Withholding

If the recipient is an employee, then the employer has to withhold income and employment taxes from the employee. This means the employee will have to write a check to the employer upon the taxing of the award.

The taxing of the award can happen either at the time of grant or upon vesting. Therefore, an employer has to have a system in place to enforce the withholding obligation. The employer also has to monitor 83(b) elections.

What If Employee Pays FMV for the Shares?

Sometimes people think that if an employee or service provider has paid fair market value for the shares that somehow the tax problems go away. This is the case if the shares are fully vested upon purchase, and the employee paid fair market value for the shares.

But if the shares are subject to vesting the tax problems are not over. If the employee does not make an 83(b) election within 30 days of receiving the shares, then the employer will have a tax withholding obligation on vesting.

What Should You Do?

Just like Fred said, taxes are the reason most employees wind up with options. Congress could fix this problem. It seems to me that it would be very pro-worker legislation to provide that gross income does not include the receipt of shares in a private company.

General Disclaimer/Warning

Please be aware that this article is a general summary. If you are considering your personal situation, know that your documents may not be standard documents, and the summary above may not accurately apply to your personal situation.

For an early stage or startup company, which type of equity incentive is better? An RSU or a restricted stock award or a stock option?

RSUs vs. Restricted Stock vs. Stock Options

The short answer is–RSUs are generally not a good idea in the early stage or startup company setting, and whether an option is better than a restricted stock award depends on two things:

the fair market value of the company’s common stock, and

the ability of the award recipient to bear tax today.

Why RSUs Generally Don’t Make Sense for Early Stage Companies

RSUs generally don’t make sense for early stage companies because they are less advantageous than either restricted stock awards or options, but entail a lot more complexity. In startupland, complexity should be avoided to keep legal and accounting costs down.

RSUs are less advantageous than options or restricted stock awards because of how RSUs work. With an RSU, the award recipient doesn’t receive stock or an option to purchase stock. Instead, the recipient receives a unit award. Not stock, but a unit award. No 83(b) election can be made on the receipt of a unit award because an 83(b) election can only be made on the receipt of actual shares of stock. (Just like you can’t make an 83(b) election on the receipt of an option; you can only make the election on the receipt of actual shares.)

There is no tax due upon the receipt of an RSU, which is good, but here is the problem: The unit award will be subject to vesting. When the units vest, the company will deliver the shares of stock to the award recipient. The shares of stock delivered will be taxable as ordinary income then, at that time. And at that time the value of the shares may have gone up substantially since when the RSU was awarded, and the taxes due may be significantly more than the recipient expected, or that the recipient can bear.

This is why in an early stage company, award recipients typically either prefer stock options or restricted stock awards.

RSUs can and do make a lot of sense for more mature companies, especially public companies that can provide award recipients with the ability to immediately sell shares to fund tax liabilities. Or companies that have significant cash reserves and that can help employees fund their taxes. Or companies that have a public offering planned in the reasonably foreseeable future. But in startup land, this is rarely the case.

The Taxation of Stock Options

Stock options are not taxable upon receipt, as long as they are priced at fair market value. This is nice, because the recipient can defer tax until option exercise. Stock options are also not taxable upon vesting. Another nice feature of stock options.

A stock option is taxable at exercise–but the tax consequences will depend on whether the option was a nonstatutory or non-qualified stock option or an incentive stock option. I have written about this extensively in other blog posts. See, for example, ISOs vs. NQOs. See also, Top 6 Reasons to Grant NQOs over ISOs.

The timing of stock option exercise is typically under the control of the optionee, post-vesting. Options are good for this reason–the optionee can generally control the incidence of the taxable event–which is exercise. Regardless of whether the option is an NQO or an ISO, the capital gains holding period does not start until exercise.

The Taxation of Restricted Stock Awards

Restricted stock awards can either be taxable upon receipt by making an 83(b) election or will be taxable upon vesting if no 83(b) election is made. Both situations are problematic. Sometimes an award recipient can’t afford the tax due if they make an 83(b) election upon receipt of the shares. And sometimes an award recipient can’t afford the tax due when the shares vest.

Thus, when considering whether to grant someone a stock award or a stock option, it is a good idea for companies to consider the ability of the award recipient to pay taxes today. If the value of the company’s stock is very low–such that a stock award will not give rise to that much tax today–stock awards can be nice because the recipient can receive stock, and start their capital gain holding period immedately.

What Should You Do?

One thing you could do is lobby your Congressional representatives to change the law.

“I do not believe there is an optimal way to issue employee equity at this time. Each of the three choices; options, restricted stock, and RSUs, has benefits and detriments.”

What could Congress do? As Dan Lear and I wrote, they could make the transfer of stock not taxable in the employer/employee context for illiquid private company stock.

Table Summarizing Some of the Differences in Award Types

Restricted Stock Units

Restricted Stock Awards

Stock Options

Taxation at Grant?

No

Yes, if vested or an 83(b) election is made

No, as long as priced at fair market value

Taxation Upon Vesting?

Yes, because usually shares are delivered upon vesting; and there is ordinary income at that time at the then value of the shares.

Yes, if subject to vesting and no 83(b) election was made

No, as long as priced at fair market value

Taxation Upon Settlement or Exercise?

Yes, ordinary income at that time at the then value of the shares.

No concept of exercise with a restricted stock award

Yes, but exact consequences depend on whether an ISO or NQO

Generalized Warning/Cautionary Statement

It is always advisable to consult with tax advisors and lawyers in evaluating the particulars of equity incentive award documents. Award documents vary widely in the wild, especially RSU award documents. And this blog post has made simplifying assumptions that may not apply in your particular situation. Good luck and have fun out there!

I’ve been writing for a long time that Congress needs to fix the taxation of employee equity–so that companies can more easily share equity with workers.

The way it works now, once a company has more than a very low value, employees can’t afford to have companies transfer them stock because they can’t afford to pay the taxes on the receipt of the shares.

Example

Let me give you an example. Suppose a startup wants to hire me, and that it wants to issue me shares. The startup has performed a valuation analysis and determined that the current fair market value of the shares it wants to issue me is $50,000.

This transfer will cost me a lot in taxes. And if I am going to be an employee of the company, I am going to have to write a check to the company for the income and employment tax withholding on the issuance of the shares. If I am an average worker, I won’t be able to afford the taxes on the receipt of the shares. I’ll have to tell the company, “Please don’t do this.”

Options

Stock options are the most frequently used alternative, but stock options are not perfect for a number of different reasons:

stock options generally have to be priced at fair market value on the date of grant to avoid adverse tax consequences to the optionee under Section 409A of the Internal Revenue Code.

typical option plans require the option to be exercised within a relatively short period of time after termination of service (e.g., 90 days).

Options do avoid the taxation to the service provider on the receipt of the option if the options are priced at fair market value on the date of grant. That is good news. But on the exercise of the option, if the option is a non-qualified stock option, the employee will have ordinary income on the spread, and will have to write a check to the company to cover the taxes (same problem as above).

“Use ISOs,” you say. ISOs have a similar problem in that the spread is an AMT adjustment and sometimes the AMT is more than an employee can bear.

Where Congress Comes In

Congress is considering a JOBS Act 2.0.

I think it ought to put on its list fixing this situation.

My Recommendations

Repeal Section 409A as it applies to startups; meaning, let companies issue discounted stock options. This will allow companies to more liberally share equity with workers.

Repeal the AMT as it applies to incentive stock options. If Congress did this, it would really fix a lot of the problems in this area.

Don’t impose tax on non-cash transfers of equity at all. This would be the perfect solution. Stock transfers to employees could be then widely used without difficultly.

Conclusion

Congress has the power to fix the tax law to substantially increase worker welfare. Congress, let’s do this.